The Dangers of Deposit Insurance

Does federal deposit insurance help contribute to bank failures? A professor at Columbia Business School, Charles Calomiris, has a new working paper out from the National Bureau of Economic Research making the case. As a historian, I was particularly interested in his account of how federal deposit insurance was created -- even President Franklin Roosevelt was against it:

Congressman Henry Steagall of Alabama lobbied successfully on behalf of his state's unit bankers for federal government deposit insurance, which initially was passed as a temporary emergency measure limited to only cover small deposits (effectively a subsidy for small banks, for whom such deposits comprised a large fraction of their liabilities). Despite the opposition of Senator Carter Glass, the Federal Reserve System, the Treasury Department, and President Roosevelt, Steagall succeeded in passing deposit insurance, which was soon transformed from a temporary to a permanent measure, and which now covers virtually all US deposits…. Opponents understood the theoretical arguments against deposit insurance espoused today – that deposit insurance removes depositors' incentives to monitor and discipline banks, that it frees bankers to take imprudent risks (especially when they have little or no remaining equity at stake, and see an advantage in "resurrection risk taking"); and that the absence of discipline promotes banker incompetence, which leads to unwitting risk taking. Deposit insurance won the day as legislation in 1933 for political, not ideological reasons, and ironically (given Roosevelt's opposition) remains the main surviving legacy of the banking legislation of the New Deal.

Though Roosevelt may have opposed the idea of deposit insurance, he did sign the legislation creating it, as Amity Shlaes points out in The Forgotten Man. Mr. Calomiris has written that he is skeptical of the political possibility of ever repealing federal deposit insurance. Even so, the discussion is not merely theoretical, because it is a reminder that bank problems are created not only by bankers but by policymakers, and that laws and policies created with the intention of stabilizing the banking system may backfire, with unintended consequences.